Liability should be a critical concern for any small business owner, as it refers to how much personal responsibility a business owner has for any debts racked up by the business. If you have unlimited liability, then your personal assets – your home, your bank accounts, etc. – are at risk.

Business Debt Danger

People don't start a business thinking that the businesses will fail, but according to the Small Business Administration, about half of small businesses fail within five years, and two-thirds are out of business within 10 years. When a business goes down, it often leaves debt behind. The question is whether that debt will become a personal burden for the owners of the business, possibly wiping them out. Protecting yourself from that liability isn't expecting failure; it's prudence – hoping (and working) for the best while preparing for the worst.

Unlimited Legal Liability

Sole proprietorships, or unincorporated businesses owned by a single person, are the most common kind of enterprise, accounting for about three-quarters of small businesses. A sole proprietorship is an unlimited liability company. Legally, the business and the owner are one and the same, so the debts of the business are automatically those of the owner.

General partnerships are also unlimited liability companies. Each partner is personally liable for all the debts of the business – even those taken on by other partners. A "limited partnership" has two kinds of partners: general and limited.

The general partners have unlimited liability; they're also the ones who run the company. The limited partners are shielded from personal liability for business debts, but they usually don't get a say in running the company.

Limited Liability Companies

At one time, the only way to guarantee limited liability for all the owners of a company was to incorporate. The shareholders of a corporation can lose the money that they have invested in the company – the price they paid for their shares, essentially – but that's it. Any debts belong to the corporation, not them. Their liability is therefore limited to whatever they put into the company.

Starting in the 1970s, states revised their commercial codes to allow businesses to operate as "limited liability companies," or LLCs. An LLC is effectively a partnership without any general partners. Its owners enjoy the limited liability protections of a corporation, but without all the corporate trappings, such as issuing stock, having a board of directors and so on.

Exceptions to Liability Limits

Even for companies with limited liability, courts can hold owners or shareholders personally liable for business debts. Legal scholars refer to this as "piercing the veil" of liability protection. There are three conditions for piercing the veil: owners not treating the business like a separate legal entity, perhaps mingling personal and business funds or ignoring corporate rules; owners knowingly acted in a negligent, reckless or criminal manner; and the company's creditors show that these actions caused them "unjust" losses – losses beyond those associated with typical business risk.

References (3)

About the Author

Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.